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The Shadows Hanging Over Stocks This Week

REUTERS/Brendan McDermid

By Patti Domm, CNBC

March 8, 2015

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With just a few key economic reports due, markets could be buffeted more in the week ahead by expectations the Fed could move sooner to hike interest rates. Stocks and bonds both sold off Friday, after surprisingly strong February jobs data fueled speculation the central bank could move sooner than expected to begin its rate-hiking cycle. The Fed meets March 17 and 18.

"Next week is the dead week before the storm of the Fed meeting," said Gina Martin Adams, institutional equity strategist at Wells Fargo Securities. "Anything can come up and surprise you in a week like that. You've got retail sales, consumer confidence and PPI." She added that the Fed will also issue its assessment of bank capital plans Wednesday.

In the past week, the Dow and S&P 500 traded lower for a second week, and the Nasdaq turned negative for the first week in five. On Monday, it had set a major milestone when it rallied above 5,000 for the first time in 15 years. The coming week marks the sixth anniversary of the bull market—on Monday—and the 15th anniversary of the Nasdaq's all-time closing high of 5,048.

Even though it is more than a week away, traders are focused on what could happen at that Fed meeting, particularly after February's 295,000 nonfarm payrolls showed a healthy labor picture. Traders speculated the central bank could now remove the word "patience" from its statement, a signal it would move to raise rates in the next couple of meetings.

"I think a lot of next week is going to be investors preparing for that Fed statement. Given the reaction (Friday), next week is going to be a lot about investors grappling with what the Fed's going to do the week after and that means it (the market) could go either way," Adams said.

John Briggs, head of cross-asset strategy at RBS, said the market's view on the timing of the first rate hike has begun to tilt more toward June after the jobs number. However, a number of economists still say the first hike will be in September, regardless of ramped-up market speculation that hikes could come sooner and be more aggressive.

"The number of rate hikes expected in 2015 rose from 1.7 to 2.1," said Briggs, citing a calculation made by RBS. The unemployment rate also fell to 5.5 percent in February from 5.7 percent.

"Because of the data, I think we've gotten a lot of the move on 'patience' coming out today (Friday)," he said. "I don't think we move that much further when 'patience' comes out." Bond yields rose dramatically after the jobs report, with the 10-year yielding 2.24 percent in late Friday trading, from a low of 2.08 percent. The two-year note was yielding 0.72 percent.

Dropping the word "patience" means the Fed will emphasize it is basing its decision to raise its target funds rate from zero, based on the quality of economic reports. Retail sales Thursday are expected to show a gain of 0.3 percent, after a decline last month. "Given the strength of the jobs number it's going to be harder to derail the current (bond market) pricing, and I'd be surprised if retail sales is strong or weak enough to move the needle," said Briggs.

With Treasury yields at higher levels, stocks sold off sharply in the past week after a strong month of February, when the S&P 500 gained more than 5 percent. The Dow finished Friday at 17,856, with a decline of 1.5 percent for the week. The S&P lost 1.6 percent for the week to 2,071, and the Nasdaq was down 0.7 percent at 4,927.

"They're going to raise in June, or they're going to raise in September. That hasn't changed. I think what we really had was a very robust month of February, and just got to a point where we're overbought," said Art Hogan, chief market strategist at Wunderlich Securities.

Several analysts have said they expected a moderate pullback in March, as the market adjusted to the idea of Fed tightening and consolidated some of February's gains. "It's hard to tell how much of this is Fed-related and how much of it's the correction that started earlier this week," said Adams of Friday's steep selloff.

Jonathan Glionna, Barclays chief equity strategist, said historically stocks trade well into Fed rate hikes, and then get a bit choppy. Barclays analysts looked at 12 previous cycles back to 1954 and found the typical pattern is that the S&P gained heading into the first rate hike but stalled for a few months before resuming an uptrend.

"You generally have good returns in the six-month period after a rate hike, and then the 12 months after the rate hike," he said. "Our economists think it happens in June, so we think it's prudent to prepare our portfolio for that event. What we found is the markets started reacting three months earlier."

Glionna said the post-rate hike gains may not be as strong this time as in other cycles, since earnings growth has lost momentum. Historically, earnings growth has been strong when the Fed starts raising rates, but S&P earnings growth now is expected to be sluggish. "We're keeping our price target (on the S&P) at 2,100 because the earnings pattern isn't as positive this time around. We're not calling for much further upside for the S&P 500 this year," he said. Glionna points out that Wall Street's consensus for earnings growth fell from 12 percent in October to just 3 percent now for 2015, over 2014.

He said the decline in oil and the strength in the dollar sapped profitability, with oil's impact shaving 6 percent off earnings growth, and the dollar knocking off 2 percent. Glionna recommends staying away from high-momentum stocks, and keeping with low-momentum names in materials, industrials or energy.

Adams also favors materials and industrials, but she says she has been concerned about a further hit to energy names if oil declines further. She has energy at market weight. "If you look at the correlation between oil prices and stock prices, it's still relatively high. We haven't shaken that relationship, and we probably won't. We need to see stable oil prices for stocks to move on and a lot of that is the energy sector and direct earnings tie. It's really tough to say investors capitulated in the energy market," she said.

Oil prices were lower in the past week. West Texas Intermediate crude futures for April were off 0.3 percent at $49.61, but Brent crude was down nearly 5 percent. Adams said oil could still be looking for a bottom. "That next leg down, if it does occur, could be pretty tough for S&P 500 earnings," she said.